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CRS SUMMARIZES INCOME TAX TREATMENT OF HEALTH CARE INSURERS.

OCT. 5, 1994

94-772 E

DATED OCT. 5, 1994
DOCUMENT ATTRIBUTES
  • Authors
    Taylor, Jack
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    insurance companies, life
    insurance companies, life reserves
    insurance companies non-life
    Blue Cross/Blue Shield
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 94-9980
  • Tax Analysts Electronic Citation
    94 TNT 218-73
Citations: 94-772 E

Income Tax Treatment of Health Care Insurers

            INCOME TAX TREATMENT OF HEALTH CARE INSURERS

 

 

                             Jack Taylor

 

                    Specialist in Public Finance

 

                         Economics Division

 

 

SUMMARY

Health care insurance is provided under a wide variety of institutional arrangements, and in many cases the income tax imposed on the activity depends on the arrangement. Commercial insurance companies are taxed as corporations, although under special insurance company tax rules that leave them more lightly taxed than most businesses. "Commercial-type" insurance offered by nonprofit organizations is taxed as unrelated business income, also under the insurance tax rules. Blue Cross and Blue Shield plans, however, are taxed under a special rule that often exempts them from the regular corporation income tax but subjects them to the "alternative minimum tax." Health maintenance organizations (HMOs) and prepaid health care plans may be subject to the regular corporate tax rules, be taxed as insurance companies, or be tax exempt. The way health care insurers are taxed affects their position in the health care insurance market and thus becomes an issue in any reform of that market under consideration.

To promote economic efficiency, taxes should generally be designed not to alter the choice between competing goods and services. Imposing different taxes on the providers of essentially the same insurance services based on how the provider is characterized violates this criterion for economic efficiency. One suggestion for a "level playing field" for taxation involves taxing all non-exempt insurers as insurance companies. This solution, however, may still leave insurance companies enjoying a tax advantage compared to HMOs operating through their own staff, an advantage inherent in the accounting rules for health insurance reserves. It would also leave tax-exempt HMOs with an advantage over other insurers to the extent that they compete for business with the taxable entities.

WAYS OF INSURING AGAINST HEALTH CARE COSTS

Insurance is the shifting of financial risk from the person subject to the risk to others able to bear or share the financial loss. In economic reality (although not necessarily in law), the sharing of risk is usually among the members of a group of people subject to the risk, under contract with a company or institution that guarantees payment, if necessary by recourse to its own funds. The company or institution that underwrites the risk (i.e., acts as insurer) determines the premiums or fees that must be charged based on its expected payments of benefits, its other expected expenses (including a return for its investors if it is a for-profit enterprise), and the expected investment earnings of the funds being held to pay claims.

Since the cost of medical care is a financial risk that virtually everyone can expect to run at some time in their lives, health insurance is a popular product offered by a wide range of companies and institutions. The type of risk-sharing contract ranges from an indemnity insurance policy that reimburses the policyholder for specified expenses to membership in a medical clinic that guarantees health care for any condition as needed. Because the income tax consequences of the various arrangements are different, it is worth examining the specifics more closely. 1

Under "conventional" insurance plans, clients contract with an insurance company or plan to cover their medical expenses, either by paying the medical practitioners directly or by reimbursing the clients. The insurer may have contracts with hospitals and medical practices to provide services for specified fees, or the contracts may call for paying limited amounts for particular services, with the insured responsible for the rest; the contracts never offer unlimited payment of all expenses. Most such insurance is actually contracted for by employers and provided to employees as a fringe benefit. 2 Almost half (49 percent) of all insured persons in the United States were under conventional insurance policies in 1993. 3

In some conventional insurance policies, such as those of the Blue Cross and Blue Shield plans, the contracted health care providers agree to charge the plans' members only the fees provided for in the contract. "Managed care" insurance plans are similar attempts to limit the cost of health care. In one form of managed care, the insurance company or plan contracts with particular health care providers for services, and plan members or policyholders are assured that they will not be charged more than the contracted amount by the providers. The provider accepts the contracted amount as full payment for his or her services. Lower co-payments and deductibles encourage the member or policyholder to use only the contract providers. These "preferred provider organizations" (PPOs) constituted about 20 percent of the market in 1993. 4

The ultimate in "managed care" is the health maintenance organization (HMO), which is an organization that provides health care directly to its members who have prepaid a fixed fee for all their care. Some HMOs provide care by contracting with medical practitioners and hospitals, and some actually operate clinics and hospitals with their own salaried staff. Traditionally members were required to use the HMO's providers in order to receive benefits; but some HMOs also allow a choice of outside providers if the member pays additional fees and co-payments (a "point-of-service" plan). HMOs covered about 22 percent of the market in 1993 and "point-of-service" plans about another 9 percent. 5

TAXING HEALTH INSURANCE ARRANGEMENTS

The employers who get tax deductions for the premiums paid on employees' health insurance and the employees who get the health insurance as a tax free fringe benefit are not directly affected by whether the insurer is a commercial company, a nonprofit plan, or an HMO. But the insurers themselves may find that their tax bills, or tax exemptions, are very much affected.

A commercial insurance company is taxed under a set of very complex rules that define taxable income somewhat differently from the definitions imposed on other types of businesses. The rules are different depending on whether the company's business is primarily life insurance or a property and casualty insurance. If the company is a life insurance company (as most commercial health insurers are 6), the rules also differ depending on whether it is a stockholder- owned "stock" company or a policyholder-owned "mutual" company. However, all insurance companies have in common one rule (or set of rules) that sets them apart from other businesses (and reduces their taxes compared to other businesses): they are allowed to deduct estimated future expenses from current income.

The normal rule for deducting business expenses is that they are deducted either in the year the expense is actually incurred or the year in which the income they were spent to produce is reported, whichever is later. Insurance companies, however, maintain "reserves," which are accounts used to show estimated expenses the company will someday have to pay. State insurance regulators require insurance companies to maintain these reserves, and Federal income tax law allows additions to these reserves for future liabilities to be deducted from current income. So long as the company's business is expanding, therefore, its tax deductions will grow faster than its income, and it will have lower tax bills than if it had to wait to take the deductions until it paid the claims. These rules also apply to any nonprofit organization that has an insurance branch taxable under the "unrelated business income tax."

The Blue Cross/Blue Shield plans were made taxable under these rules in the Tax Reform Act of 1986 (P.L. 99-514). They had been nontaxable previously, and they were given some special tax relief in that Act. The principal special feature in their taxation is a deduction equal to 25 percent of their health-related claims and expenses, limited to the amount of taxable income for the year (Internal Revenue Code section 833). The special deduction is allowed for the regular corporate tax (at rates of up to 39 percent) but not for the "alternative minimum tax" (at a 20-percent rate). Since most of the time the deduction should be greater than taxable income, most of the plans should be taxable only under the minimum tax; so the effect of the deduction is to reduce their tax rates from the regular corporate rate to 20 percent (on taxable income calculated using the reserve method of accounting, which already provides a tax benefit, as explained above). The special deduction is conditioned on the organizations providing at least some community-rated insurance and other community benefits (or being a previously tax-exempt plan presumed to have already been providing community benefits). 7

The reserve accounting rules apply only to entities whose primary business is providing insurance, which may or may not apply to HMOs. HMOs vary widely in their method of operation, and in consequence vary widely in their tax treatment. (Although HMOs are specifically mentioned in Section 501(m) of the Internal Revenue Code, there is no tax definition of HMO. 8) Some HMOs are simply prepaid medical plans operating much like many insurance plans, contracting with independent medical practices to provide services for their members. Most of these are regarded by the Internal Revenue Service (IRS) as primarily in the business of providing insurance and therefore eligible for the insurance company tax rules discussed above. Others contract with medical personnel who are not their employees but who nonetheless practice only or primarily for the HMO. Many of these also qualify for the insurance company rules, if IRS is persuaded that insurance is their principal business activity. Still others actually own medical clinics (or perhaps hospitals) with their own staff of paid medical personnel to treat their members and are taxable under the regular corporate tax rules (since their "primary business" is providing health care and not insurance). These "staff- model" and similar HMOs may operate on a "nonprofit" basis and qualify as tax exempt organizations, as most hospitals do. Even an HMO's separate insurance operation (such as a "point-of-service" plan) can be tax exempt under Internal Revenue Code section 501(m)(3)(B). Some very large HMOs are tax exempt. Most HMOs, however, are for-profit, taxable enterprises. 9

Thus, the possible income tax status of those providing insurance services for health care costs can be total exemption (nonprofit HMOs), partial taxation under the insurance tax rules (Blue Cross/Blue Shield), taxation at corporate tax rates but with the insurance tax rules to reduce taxable income (some HMOs and prepayment plans, all commercial insurance companies, and the commercial insurance operations of some nonprofit organizations), or taxation at the full corporate tax rates (taxable HMOs that do not qualify as insurance companies).

THE ISSUE OF UNEVEN TAXATION

A principle of neutral taxation is that goods and services that are essentially the same should bear the same tax burdens. Otherwise, the tax system interferes with the market forces that promote economic efficiency.

Except for two issues, it seems generally agreed that the providers discussed here are offering essentially the same products. One issue relates to the provision of health care services by HMOs, either through their own paid staff or through fixed-fee contract workers. The argument is made that the financial risk involved is borne by the medical personnel (since their receipts are fixed) rather than by the health plan, and the plan is therefore not engaged in "insurance."

Although this argument has been accepted by the Internal Revenue Service, among others, 10 from an economic perspective it is not very compelling. It applies at most to one contract period; neither employees nor contract workers would have any reason to continue to accept windfall losses because they or their employing plan mis- estimated costs. One year's losses will be reflected in the next year's contract or salary negotiations. Even within the contract period, in which the HMO would have no legal obligation to adjust its payments to medical personnel, any HMO that intended to remain in business would be likely to share the risk voluntarily. In these respects, its operation resembles the Blue Cross/Blue Shield plans or preferred provider insurance plans. The distinction between the actual operation of such an HMO and insurance seems to be very small.

The second issue arises because some HMOs are tax exempt. Tax exemption is usually justified on the grounds that nonprofit HMOs, like nonprofit hospitals, are either charitable organizations or at least provide a "community service." There are a number of criteria used by IRS and the courts to decide if nonprofit HMOs are charitable or community service organizations. These include providing medical care to a broad class of people in the community, maintaining an emergency room, subsidizing insurance costs or medical care costs, the use of any surplus funds (profit) generated for charitable and exempt purposes, and the like. 11 HMOs that actually operate in these modes could be regarded as providing a different product than commercial, for-profit companies. In 1986, the Congress accepted the proposition that the continued tax exemption of HMOs was justified, although the same justification was not accepted for the insurance operations of tax-exempt entities, and in the case of Blue Cross and Blue Shield, the same argument was used to make them taxable at a reduced rate. 12 In the Treasury Department's proposals that led to the Tax Reform Act of 1986, it was suggested that the tax exemption of insurers should be continued only for that part of a nonprofit organization's insurance operations that was truly charitable, "the providing of insurance at less than cost to a class of charitable recipients." 13

For taxable entities, one suggested way to "level the playing field" for health care insurers is to treat all as fully taxable insurance companies. 14 There is some question, however, of whether this proposal actually puts HMOs operating with their own staff on the same level as insurance companies. Reserve accounting allows an insurance company to deduct from current income its estimated liability for claims that will not be made until a future year. This defers taxes on its income to a future year also. HMOs paying virtually all expenses on a current basis, as many of them do, would have little need for reserves and thus little opportunity for a tax deferral from the use of reserve accounting. Their tax status would often be very little changed from the present rules that give rise to the problem of uneven taxation. To truly "level the playing field," it may be necessary to consider whether reserve accounting is justified for businesses engaged in providing health insurance.

 

FOOTNOTES

 

 

1 For a more complete discussion of the types of health insurance products offered, see U.S. Library of Congress. Congressional Research Service. Health Insurance Coverage in the United States: Sources, Characteristics, and Trends. Report No. 93-61 EPW, by Madeleine T. Smith, Beth C. Fuchs, and Janet P. Lundy, November 9, 1992. P. 55-62.

2 For a discussion of tax-free fringe benefits for health care, see U.S. Congress. Congressional Budget Office. The Tax Treatment of Employment-Based Health Insurance. March 1994. 59 P.

3 Gabel, Jon, Derek Liston, Gail Jensen, and Jill Marsteller. "The Health Insurance Picture in 1993: Some Rare Good News." Health Affairs, Spring 1994. P. 331.

4 Ibid.

5 Ibid.

6 CRS Report No. 93-61, P. 56.

7 U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. JCS-10-87, May 4, 1987. P. 587, 591.

8 U.S. Congress. Joint Committee on Taxation. Description and Analysis of Title VII of H.R. 3600, S. 1747, and S. 1775 ("Health Security Act"). JCS-20-93, December 20, 1993. P. 85.

9 Ibid., P.86.

10 See Neal, Philip S., and Suzanne M. Papiewski, "Taxation of HMOs Now and Under Health Care Reform -- Separating Fact From Fiction." Tax Notes, April 18, 1994, P. 359.

11 See JCS-20-93, P. 92.

12 JCS-10-87, P. 584.

13 U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth, Volume 2. November 1984. P. 287.

14 JCS-20-93, P. 94 (describing the Clinton health care reform proposal).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Taylor, Jack
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    insurance companies, life
    insurance companies, life reserves
    insurance companies non-life
    Blue Cross/Blue Shield
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 94-9980
  • Tax Analysts Electronic Citation
    94 TNT 218-73
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